Continuing our discussion on how forex brokers manage their risk and make money, here is an example.
For example, if you buy 100,000 GBP/USD, or open a “long” position, your broker takes the opposite side of your trade.
This means it will sell 100,000 GBP/USD or hold a “short” position against you.
Since you are now “long” GBP/USD, you are now exposed to the potential risk that the price for GBP/USD will decrease and you end up having to close your position by selling at a lower price than you bought it for, resulting in a loss.
The broker who is now “short” GBP/USD, is also exposed to risk. But in its case, the risk is that the price for GBP/USD will increase. If GBP/USD continues to rise, the more the broker’s loss grows.
This risk is called market risk.
Market risk is the risk of a loss in a position caused by adverse price movements.
When you start a trade with your broker, both you (the trader) and the broker are exposed to market risk.
As you can see, your trade never reaches the “market”. It stays as a private agreement between you and your “broker”.
This is why your forex broker is not really a broker. It is a DEALER.
If it was a true broker, it would find and match your trade with another counterparty. For example, if you want to buy, the broker would find someone who wants to sell.
But it doesn’t do this. If you want to buy it, It is the one that sells to you.
Since a retail forex broker is a counterparty for ALL of its traders (“customers”), this means that it holds A LOT of positions for different currency pairs.
In order to understand the market risk for a specific currency pair, we need to add ALL THE broker’s positions against traders in this currency pair.
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